What’s the Rationale Behind Entering New Option Trades?

We are frequently asked about the rationale behind when and why we choose one ticker symbol over another or use one strategy over another when building our portfolio. Today's podcast will help you understand the four-step process we use for evaluating ticker symbols and strategies when creating our options trading portfolio for each expiration. This framework should help guide you in understanding why IV rank is at the heart of our selection process but also why portfolio diversification becomes the true mechanics that govern which tickers ultimately get selected.

Choosing a Ticker

• In the long-term, it truly does not matter which ticker symbols you choose to trade.
• Research shows that no matter what diversification split you have, they all seem to converge over time.
• Of course, there will be differences from year to year as volatility levels change.
• However, the diversity mix and industry mix does not matter too much in the grand scheme of things.
• There is no right or wrong answer to what you trade!

Importance of Diversification

• Diversification of any kind helps to smooth and reduce volatility long-term.
• The added value of diversification is potentially greatest when you add the second ticker symbol. 
• As you add ticker symbols to your portfolio, there is a reduction in marginal benefit with each addition.
• For the best mix, you could have 15 to 20 positions on the high-end, 10-15 positions on the mid-to-low end. 
• You get no real diversification benefit by going beyond 20 positions.

Hierarchy of Building a Portfolio

1. High IV

• Look at high IV first, because it is the best edge you have in trading. The first level of filtering when looking for trades is choosing those with high IV first.
• High IV setups generally make more money.

2. Find Different 

• Try to find different tickers in different industries.
• For example, USO (oil), EWZ (Brazil), and GDX (commodity) are 3 different tickers across 3 different industries/sectors.
• Skip over some high IV tickers if they are all in the same industry or sector.

3. Balance Portfolio Directionally

• Once you've chosen your ticker, now you need to choose your strategy.
• The strategy comes down to what your portfolio needs - is your portfolio too bearish or too bullish?
• Choose a strategy that will help your portfolio be neutral overall so that you don't have too much one-directional risk.

4. Fill in the Gaps

• Once you have your core groupings of trades in place, fill in the gaps with other one-off opportunistic type trades.
• Ex: Tesla is not a core ticker that you would be trading regularly, but it may add an opportunity for that moment in time. 
• The tickers you choose are essentially good trade opportunities at the time to add diversity and fill in the gaps. 
• Core Positions

• US Index: DIA, SPY, IWM, etc.
• Emerging Market Exposure: EEM, EWW, EWZ, FXI, EFA, etc.
• Commodities: GLD, GDX, silver, a commodity basket, etc.
• Energy: USO, XOP, XLE, etc.
• Bonds: TLT.
• Currency: FXE, FXY, etc.
• Gap Positions

• Positions used to fill in the gaps change with volatility.
• Ex: Retail, tech, utilities, healthcare, real estate, industrials, financials, etc.

Conclusion

• The goal is to build a portfolio that has as much diversification and is as neutral as possible every month.
• Always use high IV first, while also choosing different tickers in different sectors and industries. 
• Once you have your core positions, put them together in a way that adds neutrality to your portfolio.
• Fill the gaps with core industry and sectors and tertiary industries and sectors when they have high IV.